Crowdfunding market will be learning process: study

When rules concerning equity crowdfunding are eventually handed down by North American regulators, there will be 'spectacular failures' as investors and startups 'lose significant sums' in litigation battles, warns a study

When rules concerning equity crowdfunding are eventually handed down by North American regulators, there will be “spectacular failures” as investors and startups “lose significant sums” in litigation battles, warns a study by the University of Toronto’s Rotman School of Management.

But the soon-to-be published paper in the Boston-based National Bureau of Economic Research Conference concludes that crowdfunding’s growing pains, following the first iteration of industry rules, will be smoothed over as new markets emerge as the financing model targets an “undercapitalized sector of the economy.”

“There will be steep market curve in the beginning,” Ajay Agrawal, one of the report’s authors, said in a telephone interview from the NBER Conference in Boston. He pointed to Kickstarter’s sophisticated user-based platform, noting “the market will adjust as people go through a learning process to learn from their mistakes.”

Crowdfunding pools small contributions from a broad base of private investors in exchange for securities. What remains to be known is whether this type of financing will “become significant or stay trivial” during the trial and error process, Mr. Agrawal said. He projected a “hybrid between online and offline investing” as recognized investors join the crowdfunding platform experiment.

The potential for raising equity is tremendous for startups starved of seed capital, said John Wires, a legal advisor to the National Crowdfunding Association of Canada.

“[Equity crowdfunding] democratizes access to investment opportunities,” Mr. Wires said. “The job of the securities regulators is to make sure they find the right balance between the risk of fraud and the potential benefits of funding a whole new wave of businesses.”

Stringent limits on the number of “accredited” investors a company can sell stakes to without going public means using crowdfunding to fundraise is theoretically illegal — until regulators widen the definition of investors, beyond those who meet minimum income or asset ownership levels.

The Ontario Securities Commission (OSC) and the Canadian Securities Administrators are evaluating exempt market regulations to loosen investor regimes and approve fundraising options such as crowdfunding. Last month, the country’s largest capital markets regulator gave the green light to the first online platform connecting accredited investors with issuers — Toronto-based non-profit Social Venture Connection, part of the MaRS Discovery District.

In 2012, the U.S. Jumpstart Our Business Startups Act passed with uncharacteristic bipartisan support, which equity crowdfunding proponents heralded as relaxing restrictions for non-accredited investors to pledge money in a company by bypassing the process of publishing a prospectus. But the Securities and Exchange Commission (SEC) has yet to set provisions that can protect non-sophisticated investors.

“They are fundamentally overhauling securities law and how companies are going to access capital in the future. Their task is not small,” Mr. Wires said explaining the the seven-month delay (the SEC’s deadline by Congress was in January 2013).

Critics, such as Ermanno Pascutto, executive director of the Foundation for the Advancement of Investor Rights, are concerned that crowdfunding will expose naive investors to risk from fraud or incompetence as it “abandons the fundamental principles” of securities regulation by eliminating full, transparent disclosure through a prospectus or audited financial statements. Traditional investors can offer face-to-face due diligence and are better equipped to assess risk and return than a first-time funder.

“The vast majority of Canadians are not financially literate and are not sophisticated enough to understand the risks involved,” Mr. Pascutto said of “highly speculative” crowdfunding projects.

Proponents point to the importance of the exempt market for small and medium-sized businesses that lack the resources to raise capital through deep-pocketed investors in the public markets.

The University of Toronto authors write that the online crowdfunding platforms will modify the regulatory regime by “striking the appropriate balance between minimizing the disclosure and administrative burdens on creators while maximizing the information available to funders about quality, effort, and risk of fraud.”

Mr. Wires said there is a risk of over-regulation and making the requirements too onerous. “[The regulators] risk putting issuers through such red tape that they are not going to crowd-fund anyway, which will defeat the purpose of the legislation.”